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Vanguard to Introduce Seven New Bond Index Funds on Nov. 2

Vanguard recently announced it will make an enormous new foray into bond indexing with what appears to be the goal of wresting control of the exchange-traded bond fund market from Barclays’ iShares group and going head-to-head with planned offerings from PIMCO as well as new entries that might come from the iShares acquirer BlackRock Inc.

The seven new bond index funds that Vanguard expects to introduce on Monday, November 2 track seven Barclays Capital bond indexes and will be available in institutional fund shares, Signal shares and ETF shares.

The corporate bond funds will all have front-end loads ranging from 0.25% to 1.00%, making them pretty unattractive. I would say the bulk of assets that investors send to these funds will be going into the ETFs.

A Closer Look at Vanguard’s New Bond Index Funds

As a whole, the seven bond sector funds will cover approximately 92% of the entire Barclays Aggregate Bond Index now tracked by Total Bond Market (VBMFX).

Only asset-backed bonds, foreign government bonds, taxable state and municipal bonds and commercial mortgage-backed bonds are missing from this lineup’s holdings.

Weighted-Avg.
Maturity

Sales Fee/Load

Securities in Index

Short-Term Gov. Index

1.9 years

none

447

Int.-Term Gov. Index

5.9 years

none

413

Long-Term Gov. Index

19.0 years

none

130

Short-Term Corp. Index

3.1 years

0.25% front-end

1,215

Int.-Term Corp. Index

7.9 years

0.50% front-end

1,154

Long-Term Corp. Index

24.7 years

1.00% front-end

886

Mortgage-Backed Index

5.8 years

none

1,609

The Government bond index funds will invest in Treasury bonds (excluding inflation-protected bonds) as well as bonds issued by or guaranteed by the U.S. government or agencies as well as foreign, dollar-denominated debt guaranteed by the U.S. government.

All of the funds’ portfolios will be sampled, rather than replicated by investing in all of the securities that make up the relevant indexes.

Now let’s take a closer look at how Vanguard’s new index funds stack up against their existing index funds.

Vanguard’s New Index Funds vs. Their Existing Index Funds

So, how do these new index funds stack up against both Vanguard’s existing index fund lineup as well as its active funds?

Comparisons aren’t precise since there are subtle, and not-so-subtle, differences in the bogeys that each index fund tracks, and of course the active funds have the additional manager input that can slightly alter the interest-rate risk in a portfolio, not to mention the event risk attendant to each bond that is either bought, or not bought, by the active manager. But I’ve measured the existing funds and indexes the new funds track equally since December 1999.

Let’s look at each subset.

Short-Term Government Index

Among the short-term funds, the new Short-Term Government Index looks pretty comparable to Short-Term Federal (VSGBX). Their risk profile during the 2008–2009 credit crisis was about the same, with both dropping about 1.1% at worst, before beginning to regain strength.

The weighted-average maturity on Short-Term Federal is a smidgen longer than that of the index, so one would expect that returns in a declining interest-rate environment would be slightly higher, and indeed they are at an average of 5.3% versus 4.8%.

But the even longer-maturity Short-Term Bond Index (VBISX) didn’t outperform, as would have been expected, with an average return of 5.0% over this decade. Chalk it up to the corporate bonds in that index, which took such a drubbing last fall.

I believe Short-Term Government Index will be a useful substitute for cash for ETF investors looking to boost yields a bit, but won’t hold a candle to a fund like Short-Term Investment-Grade (VFSTX), which I consider a great cash substitute for long-term investors.

Short-Term Corporate Index

But what about the proposed Short-Term Corporate Index and Short-Term Investment-Grade? The index has a slightly longer maturity so, again, it should be expected to have outperformed over this past decade, and on average it has returning 5.1% versus 4.2%. But in so doing it also experienced a larger loss during the credit crisis, notching an MCL of -9.7% versus Short-Term Investment-Grade’s -7.6% decline.

Intermediate-Term Government Index

On the intermediate-maturity side, as with the long-term options, Vanguard doesn’t have a “Federal” fund, so comparisons are bit tougher. The Intermediate-Term Government Index has essentially the same maturity as Intermediate-Term Treasury (VFIUX) but is shorter than Intermediate-Term Bond Index (VBIIX). This index did exceptionally well during the crisis, marking an MCL of just -3.1% versus the Treasury fund’s -3.4% loss and of course the corporate-bond burdened index fund’s 8.9% decline. I’m guessing the agency bonds in the index provided a high enough yield that they more than made up for losses generated when investors sold longer-maturity bonds in a panic.

Intermediate-Term Corporate Index

The Intermediate-Term Corporate Index, however, with its longer maturity portfolio, took a bigger hit during the crisis, and its “worst” 12-month return of -15.7% was a doozy compared to the worst-case losses for its competitors.

Long-Term Government Index and Long-Term Corporate Index

On the long side, the new Long-Term Government Index and Long-Term Corporate Index hold fairly long bonds relative to the existing Vanguard funds. It’s a testament to great management to see how well Long-Term Investment-Grade (VWESX) held up relative to the corporate index, generating better average returns and smaller losses.

Mortgage-Backed Securities Index

Comparisons between GNMA (VFIIX) and the new Mortgage-Backed Securities Index are tough since the index holds both Fannie Mae and Freddie Mac bonds in addition to Ginnie Maes. One would expect the shorter average maturity of the GNMA fund might have kept losses lower, but mortgage bonds don’t really react to interest rates in the same way as plain vanilla bonds, since falling rates tend to lead to refinancings, which can cut yields, and returns. In any case, the new index fund could be a big winner for Vanguard.

Outlook

Of course, what goes without saying is that some of these funds, particularly those with longer maturities, may languish for lack of interest if interest rates begin rising and bond prices begin falling.

When Vanguard introduced its original three sector bond index funds in March 1994, the Fed had just begun to raise interest rates, doubling the Fed Funds Rate from 3.00% in February 1994 to 6.00% in February 1995.

Falling bond prices were a headwind to market acceptance, and Long-Term Bond Index struggled to build assets, while Short-Term Bond Index and Intermediate-Term Bond Index grew fairly quickly. The intermediate-term fund topped $1 billion in assets by 1998 and the short-term fund by 1999. It wasn’t until 2004 that the long-term fund saw assets break the billion-dollar mark.

Only hindsight will tell us how successful a November 2009 launch for this septet of sector bond index funds will be. I’ll keep you posted.